Download Monetary Policy as a Carry Trade

Monetary Policy as a Carry Trade
Marvin Goodfriend
Carnegie Mellon University
90th International Business Cycle Conference
World Economic Outlook: New Directions for Economic Policy
Kiel Institute for the World Economy Austrian Embassy, Berlin
September 15‐16, 2014 Outline
1) How must a central bank acquire “operational credibility” for monetary policy against deflation and inflation at the zero interest bound…
2) Must be seen willing to expand bank reserves to purchase long‐term securities on unprecedented scale far beyond limits ordinarily thought prudent
3) Needs interest on reserves to raise interest rates without shrinking its balance sheet—Credibility against deflation tied to credibility against inflation
4) Monetary policy should be conceived as a “carry trade”—CB must prepare to carry long bonds by paying market interest on reserves created to purchase the bonds
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Outline (2)
4) Four aspects of the monetary carry trade: Why run a carry trade?
What is the nature of cash flows and risk?
How are bank reserves immobilized?
What is the negative cash flow problem?
5) Fed has long asserted authority to retain surplus capital thought necessary against financial exposures • It is widely agreed that retention of Fed surplus capital has no resource cost for the Treasury or taxpayers • Fed has not retained surplus capital above modest longstanding level even though its assets are up from $1 trillion in Sept. 2008 to $4.5 trillion by end of 2014, $3 trillion of securities with average 10 yr. maturity financed by short interest, and Fed remitted $320 billion to Treasury since 2010 • Failure to retain carry trade earnings compromises Fed “operational credibility” against both inflation and deflation
6) Treasury securities acquired by the Fed should be exempted from the federal debt ceiling to facilitate retention of Fed net interest income against carry trade costs and risk 3
Monetary Policy at Zero Interest • Narrow liquidity provided by currency and bank reserves is satiated at zero bound
• Broad liquidity not satiated, valued because it minimizes exposure to external finance premium
• Demand for broadly liquid assets provides leverage for quantitative monetary policy at zero interest
• CB policy priority at zero interest is to establish “operational credibility” against deflation (and inflation) 4
Monetary Policy at Zero Interest (2)
• CB must be prepared (and convince markets that it is prepared) to deliver large and immediate dose of broad liquidity stimulus against deflation • To do so, CB must extend maturity of open market purchases from usual short‐ to long‐term less liquid securities to facilitate immediate delivery of broad liquidity stimulus
• Monetary policy must act on economy‐wide stock of broadly liquid assets‐‐‐about the size of GDP
• Three waves of Fed QE followed this logic—
played critically important, if not decisive role in averting deflation in wake of Great Recession
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Role of Interest on Reserves
• Fed began to pay interest on reserves in Oct 2008 after expedited authorization granted in Financial Services Regulatory Relief Act of 2006
• Interest on reserves creates a floor below which banks will not lend to each other
• As initially envisioned—interest on reserves would enable Fed to create reserves on massive scale to help finance the re‐intermediation of distressed banking and credit markets‐‐‐without lowering the fed funds rate
• But Fed cut interest to near zero in Dec 2008 against the Great Recession
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Role of Interest on Reserves (2)
• Nevertheless, interest on reserves proved crucial for establishing operational credibility at zero interest against both deflation and inflation
• Fed had to show itself undeterred from overshooting its balance sheet against deflation for fear of triggering inflation
• Oct 2008 power to pay interest on reserves allowed the Fed to do just that…
• Because enabled Fed to reverse field and raise market interest quickly and aggressively against inflation, if need be, without first shrinking its balance sheet
• Credibility against deflation is tied to credibility against inflation 7
Monetary Policy as a Carry Trade
• By end of 2014, Fed will have created about $3 trillion of bank reserves since Sept 2008; roughly $1 trillion to re‐intermediate banking and credit markets in fall and winter 2008‐09; around $2 trillion more in 3 waves of QE; to expand Fed assets to $4.5 trillion; doubling average maturity from around 5 to over 10 years; with average coupon yield around 2.5% 8
Monetary Policy as a Carry Trade (2) • Bond market carry trade‐‐‐A financial position that involves the acquisition of higher‐interest long bonds with funds acquired by the issuance of lower‐interest short term liabilities
• Fed’s balance sheet reflects a carry trade in that by end of 2014 about $3 trillion of reserves paying ¼% will finance two thirds of its portfolio of long securities earning an average of 2.5%
• Furthermore, for operational credibility against deflation and inflation, the Fed must be prepared to pay interest on reserves in line with market rates to carry $3 trillion of bonds, as short‐term interest rates exit the zero bound against inflation
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Monetary Policy as a Carry Trade (3)
WHY RUN A CARRY TRADE?
• Could sell long securities and contract reserves before exiting zero bound‐‐would take time
• Implementation lag would assume risk of inappropriate timing, inadvertent signal
• Discretionary unwind would disrupt bond markets, push prices against Fed
• Best to hold bonds to maturity, shorten asset maturity or unwind long bonds gradually over time according to pre‐announced rule
• Central bank should be prepared to raise interest against inflation before unwinding much of monetary carry trade 10
Monetary Policy as a Carry Trade (4)
CARRY TRADE CASH FLOWS AND RISK
• An entity that runs a carry trade persistently and unconditionally can expect the PDV of earnings on the front end of the trade to be offset (up to the PDV of a term premium) by the PDV of interest costs or realized capital losses on the back end
• Likewise, a CB that carries long bonds on its balance sheet can expect to “give back” earnings accumulated on the front end up to those reflecting the return to risk bearing and forgone liquidity reflected in the term premium
• If the CB prepares to hold long bonds to maturity, the unconditional expected return will be the term premium
• A CB that “overpays” for long bonds to bring down long interest might be expected to drive the term premium toward or below zero 11
Monetary Policy as a Carry Trade (5)
CARRY TRADE CASH FLOWS AND RISK (cont.)
• Monetary carry trade assumes risk due to potential errors forecasting future short‐term interest rates
• Monetary carry trade takes unexpected losses if future short‐term interest rates (interest paid on reserves) must rise sooner than expected against inflation or settle higher than expected, especially if CB allows higher inflation to take expected inflation and nominal interest rates higher 12
Monetary Policy as a Carry Trade (6) HOW BANK RESERVES ARE IMMOBILIZED
• The CB could raise market interest rates promptly, precisely, and flexibly by paying interest on reserves in line with the desired policy stance
• The large volume of reserves created by the CB at the zero bound would continue to put downward pressure on interbank interest
• But interest on reserves would put a floor under which banks would not lend
• The interest‐on‐reserves floor would continue to immobilize bank reserves as they were immobilized at the zero bound, because interest on reserves would perpetuate the zero interest opportunity cost of reserves
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Monetary Policy as a Carry Trade (7) HOW BANK RESERVES ARE IMMOBILIZED
• As of April 2014 US banks held around 25% reserves against deposits
• CB should prepare additional means of immobilizing bank reserves in case aggregate reserves ever exceed the volume that banks are willing to hold even at zero opportunity cost
• CB “managed liabilities” could be issued flexibly and in quantity to help absorb and immobilize bank reserves on short notice
• The Fed introduced term deposits and reverse RPs to do so • Managed money market liabilities would not pay interest much different than reserves and not change much the interest cost of the CB carry trade; they would help fine‐
tune the stance of interest rate policy in money markets
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Monetary Policy as a Carry Trade (8)
HOW BANK RESERVES ARE IMMOBILIZED
• Reserve requirements could be imposed flexibly and in size to help immobilize reserves on short notice
• But costly to enforce and administer on large scale, especially if little or no interest paid on required reserves
• Reserve requirement tax would hurt bank profits, encourage avoidance
• Hence, reserve requirements employed on large scale as primary tool to immobilize reserves would have to pay at or near the market rate, and save little or nothing on interest cost of the monetary carry trade
• At best, reserve requirements might supplement interest on reserves and managed money market liabilities as a means of immobilizing reserves 15
Monetary Policy as a Carry Trade (9)
THE NEGATIVE CASH FLOW PROBLEM
• Net interest margin can be expected to go negative on the back end of the monetary carry trade as interest the CB must pay on reserves and managed liabilities rises above the low coupon interest earned on long bonds [Fed long bonds earn 2.5%; as fed funds rate goes to ~4%]
• Non‐interest bearing currency helps prevent a negative net interest margin from producing a negative cash flow problem
• But currency cushion can be overcome if CB is either insufficiently preemptive against deflation or insufficiently preemptive against inflation
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Monetary Policy as a Carry Trade (10)
THE NEGATIVE CASH FLOW PROBLEM
• A CB too slow to act against deflation at the zero bound ultimately might have to buy trillions of dollars of long bonds at exceptionally low interest to contain and reverse deflation
• Alternatively, a CB too slow to exit the zero bound against inflation might have to raise interest on reserves aggressively and persistently far above interest on its long bonds, especially if an inflation scare unhinges inflation expectations
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Monetary Policy as a Carry Trade (11)
THE NEGATIVE CASH FLOW PROBLEM
• A CB with the power to create money in the form of bank reserves or managed money market liabilities is uniquely positioned to finance a negative cash flow “gap”
• But a CB must recognize that “having to create money to stabilize the value of money” would jeopardize the credibility of its commitment to maintain low inflation
• Creating reserves (or borrowing) to pay interest on its monetary liabilities would unnerve and likely unhinge inflation expectations, especially if at all protracted
• A CB should steer clear of ever creating reserves or managed money market liabilities to finance a negative cash flow gap
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Monetary Policy as a Carry Trade (12)
THE NEGATIVE CASH FLOW PROBLEM
• CB could sell long bonds to finance a negative cash flow “gap,” but discretionary sales would disrupt markets, and realize capital losses that would accrue more gradually and less visibly, if at all, in future cash flows
• Best to retain earnings on front end of monetary carry trade as “surplus capital” in short‐term liquid securities
• Could sell liquid securities to finance a negative cash flow gap, realizing little or no capital loss
• Public should be made to understand that net interest cost the CB will likely incur to stabilize inflation on the back end of its carry trade is “paid for” in large part, if not in full, by net interest earnings on the front end of the carry trade together with long‐bond interest earned on the back end 19
Fed Surplus Capital and Carry Trade
BRIEF HISTORY OF FED SURPLUS CAPITAL
• Fed Reserve Act 1913 requires that each member bank subscribe to Fed capital stock an amount equal to 6% of the capital and surplus of the member bank; must adjust as member bank capital and surplus changes; only ½ of subscribed capital has ever been “paid in,” Fed pays 6% interest on paid‐in capital
• Initially, FRA authorized Fed to retain interest income until surplus capital reached 40% of paid‐in capital of member banks; then net earnings after expenses were to be transferred to the Treasury as a “franchise tax” 20
Fed Surplus Capital and Carry Trade (2)
BRIEF HISTORY OF FED SURPLUS CAPITAL
• 1919 FRA amended to raise surplus to twice paid‐in capital
• Banking Act of 1933 transferred ½ surplus to capitalize the FDIC; in return, Congress abolished franchise tax, allowed Fed to retain subsequent earnings to rebuild surplus
• Present basis for Fed‐Treasury transfers set in 1947 as part of Accord freeing Fed from WW2 interest peg
• Fed voluntarily resumed transfers as “interest on Federal Reserve notes”
• In 1959 Fed voluntarily set surplus at twice paid‐in capital as in 1919 • In 1964 Fed voluntarily reduced surplus to paid‐in capital
• Fed has transferred to Treasury 100% of net earnings after maintaining surplus at paid‐in capital to this day
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Fed Surplus Capital and Carry Trade (3) FED INDEPENDENCE OVER SURPLUS CAPITAL
• Fed asserts independent authority over size of surplus capital, see 2012 Annual Report, p. 260
• GAO (1996, 2002)—Level of surplus is matter of Fed policy; amount and timing of Fed transfers to Treasury not regulated by law; Fed has discretion over Fed‐Treasury transfers
• GAO (2002)—Fed says primary purpose of surplus account is to provide capital to supplement paid‐
in capital for use in the event of loss 22
Fed Surplus Capital and Carry Trade (4) FED INDEPENDENCE OVER SURPLUS CAPITAL
• GAO (2002)—Fed and CBO agree that retaining Fed earnings to build up surplus capital incurs no resource cost for the Treasury or taxpayers
• Reason: If Fed sells a security from its surplus account and transfers the proceeds to Treasury, then Treasury loses the interest on the security it would have received from the Fed; it is as if Treasury issued a new security to borrow the funds in the first place. Conversely, retaining earnings, acquiring a security for Fed surplus account, and transferring that new interest is as if the Treasury retires a security that it had borrowed against previously 23
Fed Surplus Capital and Carry Trade (5)
FED SHOULD RETAIN MONETARY CARRY TRADE EARNINGS
• By end 2014 around 1/3 of the Fed’s $4.5 trillion of securities (with average maturity over 10 years earning roughly 2.5% coupon interest) will be financed with roughly $1.5 trillion of non‐interest paying currency
• The FOMC projects short nominal interest to normalize around 4%, so eventually Fed can expect a negative net interest margin on the back end of its monetary carry trade • The one‐third currency cushion means that the roughly 2.5% interest on the Fed’s long bonds could finance at most 3.75% interest on the Fed’s $3 trillion reserves and managed money market liabilities before encountering a negative cash flow problem
• Reserves or managed money market liabilities created to finance interest payments above 3.75% would grow Fed interest‐paying liabilities without acquiring new assets, exacerbating the negative cash flow problem
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Fed Surplus Capital and Carry Trade (6)
FED SHOULD RETAIN MONETARY CARRY TRADE EARNINGS
• In spite of such exposure to negative cash flow risk, the Fed has not retained as surplus any of the earnings on the front end of its carry trade
• The Fed has continued its long‐standing practice of transferring to the Treasury 100% of net earnings after maintaining surplus at paid‐in capital, a level of surplus capital geared to the historically low financial exposures and risks on the Fed balance sheet • As a result, surplus capital stands as of April 2014 at only $25 billion, 0.66% of the Fed’s $4 trillion balance sheet down from about 2% of its balance sheet in Sept. 2008
• Meanwhile, the Fed remitted to the Treasury around $80 billion per year from 2010 through 2013 on the front end of its monetary carry trade 25
Fed Surplus Capital and Carry Trade (7)
FED SHOULD RETAIN MONETARY CARRY TRADE EARNINGS
• Had the Fed understood its monetary policy at the zero bound as a carry trade, the Fed would have had good reason to withhold (some if not all of) the $320 billion earnings transferred to Treasury since 2010 in order to make available additional surplus capital in short term Treasuries to help meet a negative cash flow gap, if need be
• This, especially since the Fed as a matter of policy has long had discretion over the amounts it transfers to Treasury and the level of surplus capital it chooses to retain against its financial exposures
• And also because earnings retained to build Fed surplus capital deprive the fiscal authorities of no resources • Moreover, earnings on the front end of the monetary carry trade should not be regarded as “booked profit” to be distributed to the fiscal authorities, since they come with a likely future reverse flow • Monetary carry trade earnings should be expected in large part to be “given back” as net interest costs or realized capital losses on the back end of the monetary carry trade, and they should be withheld against risk inherent in the monetary carry trade itself 26
Postscript: The Federal Debt Ceiling and Fed Surplus Capital • Only the federal debt ceiling makes a suspension of Fed transfers costly for the Treasury • The problem is this: The sale of new debt by the Treasury in lieu of Fed transfers would use up debt capacity under the federal debt ceiling
• This is a problem for the Treasury even if the Fed buys Treasuries with the retained surplus, because Treasuries held by the Fed count as outstanding debt under the federal debt ceiling
• A solution could exempt Treasury securities acquired by the Fed from the debt ceiling at least until the Fed can normalize its balance sheet 27
The Debt Ceiling and Fed Surplus (2)
• Legislation signed into law in February 2014 suspends the federal debt ceiling through March 2015, allowing the Treasury to sell debt it deems necessary until then
• The Fed could use this window of opportunity to suspend transfers to the Treasury
• If interest rates remain at the zero bound, a suspension of transfers now would enable the Fed to accumulate around $40 billion of surplus by March 2015
• The Fed could work to get an exemption for its accumulation of Treasuries from the debt ceiling after that
• Each $100 billion of surplus capital could pay for approximately an additional 1% interest for three years on the $3 trillion Fed reserves and managed money market liabilities 28